Monday, March 09, 2009

Son of man...

"What are the roots that clutch, what branches grow Out of this stony rubbish? Son of man:You cannot say, or guess, for you know only A heap of broken images, where the sun beats...

Waste Land - T.S. Eliot"

In the wake of the financial crisis, people called for more regulation. Regulation and transparency. More regulation by whom? By the same people who got us into this mess? By the same people who were running a Ponzi scheme, and Nasdaq at the same time?

I think we generally tend to underestimate our inclination to make mistakes, overestimate our powers to solve them, and our willingness to ignore them. In my humble opinion this is the fundamental reason behind the crisis we are facing now. To understand which simple flaws in human behavior lead to the crisis, I recommend the brilliant animation by Jonathan Jarvis, titled "Credit Crisis Explained". Thanks to Engin for bringing to my attention.

Those who are interested in the actual "financial sorcery" mentioned in the animation, which is nothing more than a make believe "pseudo-scientific" formula relating mortgages failure rates to the price of the insurances on them, should read this great WIRED article.

In a nutshell, what the complete "financial industry" was the following:

1- Take a risky credit.2- Group a lot of them, and formulate a measure of correlation between them.3- Since there were not enough data about the credits themselves, they used the insurance paid for these credits to find the correlation. And this in a time when the insurance rates were relatively low. 3- If the correlation is low, the bundle is less risky than the individual credits, if they are highly correlated, they are as risky as the original credits. 4- Use this correlation as a overly simplified descriptor of the risk of the bundle, and sell them to companies for a profit5- Using borrowed money from the Central Bank, which was getting a lot of money from Chinese government6- Who was making a lot of money selling to consumers who were taking these credits in the bullet one

Circular logic, make believe modeling, oversimplifications. There is no way this would pass as an engineering project. No wonder why all the engineering drop-outs ended in finance :)

Finally, I was reading the reaction of Berliner's to the financial crisis in the Spiegel. A restauran owner said:

"All this talk of financial crisis... Is just bankers last cries. I mean, we could not grow 4 percent this year, so what?"